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We've all heard that if we invest money in the stock market, that we can earn 10-12% returns, right? If that's true, then someone investing $10k per year at an annual average return of 11% would have a little over $700k after 20 years. Not bad. Unfortunately, it's not quite that simple or easy. Here are some reasons why you can't count on that 10-12% return:

"Average" Returns vs. "Annualized" Returns

The first problem is the use of "average annual returns," which the financial industry often uses to make past returns look a little better than they actually were. This number is calculated by simply taking an average of annual returns over a given period. Let's say you owned a single stock that was valued at $100 and the market increased by 100% in the first year and lost 50% in the next year. 100% minus 50% divided by 2 would give us a 25% annual average return and we would expect our value to be $125. But in reality, the $100 would have gone up to $200 ($100 plus 100% increase) and then dropped back down to $100 ($200 reduced by 50%), leaving us with exactly as much money as we started with for a 0% return.

The more volatile the returns are, the more distorted the numbers will be so this is an extreme example but even a small difference in returns can have a huge impact. For example, according to this web site, the average annual return of the S&P 500 (including dividends) was about 9.6% from 1992-2011. However, the compounded annualized return (what you actually earned once volatility was factored in) was about 7.8%. That might not seem like a big difference but $10k a year over 20 years at a 9.6% return is about $600k. At a 7.8% return, it's a little over $480k. That's almost a $120k difference. Over a longer time period, the gap would only continue to grow.

Lump Sum v. Systematic Investing

But wait, it gets worse. Both the average annual and the compounded annualized returns are based on investing a lump sum of money at the beginning of 1992. That works great when you invest in the middle of a long term bull market but not so great when you're investing over time into a market with lower returns near the end of the last 20 years as most people have actually been doing. After all, a lot of your money never got to experience the bull market that ended in 2000.

How much of a difference would that have made? According to the latest Dalbar report, someone investing systematically from 1992-2011 would only have earned about a 3.2% compounded annualized return compared to the 7.8% return if they invested all at once in 1992. At that 3.2% return, our $10k a year would have actually grown to only $280k.

This assumes we continued investing the same amount through thick and thin. If we panicked and stop contributing or even bailed out of the market during the downturns, our returns could have been even less. A recent Fidelity study showed that investors who got out of the market during the 2008 financial crisis only earned back 2% of their portfolio as of the middle of last year while those who stayed the course, earned back 50%. Those who continued contributing did even better, earning 64%, while those who stayed invested but stopped contributing earned 26%.

Mutual Fund Fees and Trading Costs

Of course, you can't invest in the S&P 500 directly. At the very least, you'd have to pay commissions to purchase each stock and most people invest in stocks through mutual funds, which charge all kinds of fees. Let's assume that you don't buy a load fund from a broker or pay a management fee to an investment advisor and just focus on the expense ratio, which is a measure of the annual fees charged by the fund. Last year, the weighted average expense ratio of actively managed mutual funds was .93%. Most actively managed funds underperform the market but we'll be generous and assume you invested in a fund that did as well as the S&P 500 minus that .93 fee or 2.27%. In that case, your $10k a year would have grown to $252k after fees.

It also doesn't factor in hidden costs that can be incurred every time a fund buys and sells a stock. There's the bid-ask spread or the difference between the highest price a buyer is willing to pay and the lowest price a seller is willing to accept. In addition, when a large fund makes a trade it can push the price of a stock higher when it buys and lower when it sells.